Payback Period Method - Meaning, Formula, Calculations, Advantages & Disadvantages

Payback Period

The payback period method in capital budgeting state that "How much time required to get back a recovery amount of an initial cost of an investment on a project". The payback period is the time required to earn back the amount invested in an asset from its net cash flows. It is a simple way to evaluate the risk associated with a proposed project. The payback period is expressed in years and fractions of years. For example, if a company invests ₹500,000 in a new production line, and the production line then produces positive cash flow of ₹100,000 per year, then the payback period is 5.0 years (₹500,000 initial investment ÷ ₹100,000 annual payback).

Formula

Total Outflow / Inflow every year

or, Initial Investment / Net annual cash flow

Calculation

ABC Company has two option for projects. The initial investment for both the projects is ₹10,00,000.
Project A has even inflow of ₹1,00,000 for every year.
Project B has uneven cash flows as follows:
Year 1 - ₹2,00,000
Year 2 - ₹3,00,000
Year 3 - ₹4,00,000
Year 4 - ₹1,00,000

Solutions
Now let's apply payback period method on the given projects.

Project A
Initial Investment / Net annual cash inflow
₹10,00,000 / ₹1,00,000 = 10 years

Project B

Now, let us modify the cash flows of project B and see how to get the payback period:

Say, cash inflows are –

Year 1 – ₹ 2,00,000

Year 2 – ₹ 3,00,000

Year 3 – ₹ 7,00,000

Year 4 – ₹ 1,50,000

The payback period can be calculated as follows:

Years	Total Flow	Cumulative
0	10	10
1	2	8
2	3	5
3	7	-2
4	1.5	-3.5

Step 1: We must pick the year in which the outflows have become positive. In other words, the year with the last negative outflow has to be selected. So, in this case, it will be year two.

Step 2: Divide the total cumulative flow in the year in which the cash flows became positive by the total flow of the consecutive year.

So that is: 5/7 = 0.71

Step 3: Step 1 + Step 2 = The payback period is 2.71 years.

Therefore, between Project A and B, solely on the payback method, Project B (in both the examples) will be selected. The example stated above is a very simple presentation. In an actual scenario, an investment might not generate returns for the first few years. Gradually over time, it might generate returns. That too will play a major role in determining the payback period.

Advantages of Payback Period Method

Easy to Use and Understand
A longer payback period indicates capital is tied up.
Focus on early payback can enhance liquidity
Investment risk can be assessed through payback method

Disadvantages of Payback Period Method

It ignores the timing of cash inflows within the payback period
It ignores the cash flow produced after the end of the payback period and therefore the total return of the project.
It ignores the time value of money
It influence for excessive investment in short term projects